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Friday, 30 June 2006

Not 'market failure': government failure

'Market failure' is an anti-concept designed to allow government intrusion into places they have no right be. Glenn Woiceshyn takes the anti-concept to task:

[T]here is no such thing as “market failure.” Like the unicorn, it doesn’t exist.

To say that something failed means it did not meet a standard that it was designed to or capable of meeting. For example: “a valve failed to open” or “a student failed a math test.” The free market refers to a group of people involved in the voluntary exchange of goods and services. It presupposes that each individual participates to pursue his or her rational self-interest and that a government exists to protect individual rights, including property rights. It’s based on the recognition that everyone can benefit from division of labor and free trade.

A free market doesn’t guarantee that an individual will act in rational self-interest—errors are possible—only that he or she is free to do so. If a person fails to act as such, then it’s the person’s failure, not “market failure.”

. . . if the activities of some people harm others, such as harmfully pollute their water or air, and if the harm can be objectively proven (a concept foreign to environmentalists), then it’s the government’s failure to protect individual rights—not “market failure.” And a tax on emissions is not a valid solution, because it implies that it’s okay to violate rights as long as you pay government for the privilege.

Market failure? As Woiceshyn concludes, "anyone who makes the charge of 'market failure,' should be charged with 'intellectual failure'."

9 comments:

If you read "market failure" as meaning "failure to do as well as government might do instead", then you might be right about unicorn-chasing. But that isn't what the term means. Ask any economist. Market failure means that something underlying the first welfare theorem went wrong and so there exist unrealised pareto improvements. Nothing specifies that government can necessarily improve outcomes.

Think of it more like engineering efficiency. No engine is 100% efficient -- some potential work is lost as heat waste. But that doesn't damn the engine as consequence. Nor does it imply that government can build a better engine. But we need the 100% efficiency standard against which to benchmark things.

I am an economist. At least thats what that large scrap of paper on my wall says. And I disagree with the concept of market failure. It is unicorn chasing, at best, a dishonest tool at worst.

Firstly the welfare theorem is a load of nonsense. I notice you care not to define such terms. Your anology betrays your error. Individuals in a free market are not in any way a machine. They are not trying to achieve a singular goal, but rather a plethora of individual, context related, goals. As such, how can you hold one standard to an infinite number of different goods? How can you actually measure such a thing? Who is this collective "we"? People can decide whats working for them and adjust according. Entrepreneur's correct mistakes in the market place - thats how they make money.

Perfect competition is not a bench mark, but a fiction. Often the conclusions dervived from this standard undercut the very foundations of economics. As every stage one student learns, often the legal and political framework (read private property rights and free trade) of a country determine more economic growth than a bland prduction functions. Any damage to the framework (even in the name of competion) ultimately leaves everyone worse off.

It's a mistake to impute a normative status to "failure" -- is just a comparison to a theoretical ideal. It sucks that the concept got labelled "market failure" because it's really easy for folks to read into it that there might be some superior alternative. But it's the term we're stuck with. Economists have pointed out for at least 40 years (Demsetz '67 is the earliest piece I can think of) that "market failure" doesn't mean that anything else necessarily is better.

Note also that while the bit you quoted talks about people not acting rationally as the basis for failure, that isn't what economists studying market failure generally are talking about. Instead, they're talking about public goods, externalities, asymmetric information, or maybe market structure or path dependence.

Sean: I agree that attempts to remedy market failure generally make things worse. And I agree that perfectly competitive markets are just a benchmark model that one shouldn't expect to hold in the real world.

What do you mean "market failure" doesn't exist? Within the terms of debate as they have been defined, you're arguing that the first welfare theorem holds always and everywhere, which is clearly a nonsense. Now, if instead you mean that the term is misapplied -- that we never should have called it market failure -- that's something different. But it's semantic.

Yes, market failure arguments have been used to justify a whole host of really stupid policies. That doesn't mean that the deviations from the first welfare theorem do not exist; rather, it means that folks have made serious errors in thinking that they can improve on those outcomes.

The first welfare theorem just says that when individuals trade in competitive markets without externalities, the resulting equilibrium is such that it is impossible to make anyone better off without simultaneously making someone else worse off.

When the first welfare theorm fails to hold, it may be theoretically possible to have a change that makes at least someone better off at no cost to anyone else. But, in practice, government interventions aimed at that end have made things much worse instead.

The analogy wasn't meant to posit individuals as machines but rather to say that an efficiency benchmark can be useful even if it's generally impossible to reach that benchmark.

while this is largely a semantic issue, I think that is the concern. The perjorative word "failure" is attached to the word market and is said to apply in any situtaion when not every possible pareto improvement is identified and carried out.

I see this as analogous to the term "perfect competition" where a market is only considered to be perfect if it is impossible for a firm to make profits (at least ex ante). How can a market where businesses cannot make money be perfect, and one where they can make money be imperfect?

While at one level "perfect" and "failure" are only words being used to describe a certain theoretical state, and some other words could have been used, what interests me is why those words were chosen. It seems to me the only explanation is a political/sociological overlay on economics seeking to smear free markets and business profits, and one usually with a pro-state interference agenda.

My point is that the very terms/definitions/assumptions of the debate are based on false premises. We economists have a terrible habit of just accepting the asumptions of the past greats without question.

"The first welfare theorem just says that when individuals trade in competitive markets without externalities, the resulting equilibrium is such that it is impossible to make anyone better off without simultaneously making someone else worse off."

By what standard? What is the good? How is that we can dole it out to everyone like vitimins? (BTW don't get me started on externalities) The theoritical stadard is absurd, because it bears no relation to reality. It is arbitrary and therefore irrational. Where your engine may be a fair standard in racing - perfect competion and the welfare theorem are philosophically bankrupt.

Market failure is not a failure of the market, but a failure of the model!

Nik: I'll agree with Alex Tabarrok that "Market challenge" is a more appropriate term than "market failure" as it points out an area where we'd most expect creative entrepreneurs to be able to profit -- entrepreneurs read deadweight losses as potential profits to be gained by identifying the impediment to trade caused by the market challenge (market failure) and solving the problem.

Sean: in the pure theory, we're defining the standards and the good only with reference to each individual's own preferences. In the absence of market failure, competitive markets produce a result such that no individual can be made better off *as he himself defines better off* without making someone else simultaneously worse off *as that person himself defines worse off*. It's hardly an arbitrary standard -- the Pareto criterion is the strictest and most objective standard possible in economics; moreover, it's a standard that takes very seriously individual sovereignty.

Rather than damning the standard for being unattainable, we should instead marvel at how close we're able to come despite the strictness of the standard. The first welfare theorem basically says that if there existed an omniscient and omnipotent entity who could see directly into everyone's mind and know their full sets of preferences, that entity would come up with the same solution as the market already does. There's no god and the market isn't "perfect", but it's a damned miracle how well the price system works. That's the basic message of Hayek's 1945 piece: still one of my favourites.

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